Private equity acquisitions in the U.K. and the U.S. share many similarities but also some crucial differences. Two of the key differences frequently seen in these transactions include how the purchase price to be paid by the buyer is structured and how sellers and buyers allocate risk in terms of potential claims for breaches of representations and warranties in the purchase agreement. Interestingly, we are seeing some signs of convergence in how these issues are addressed between the U.K. and the U.S.
Structuring Purchase Price
U.S. Approach: Working Capital True-Up
In the U.S., the vast majority of private company acquisitions continue to be done with the purchase price determined at closing (usually based on an estimate with a post-closing true-up adjustment). The standard calculation uses the enterprise value of the target with adjustments for actual cash, debt and working capital (relative to a normalized level of working capital) at closing.
On the positive side, buyers have comfort that they are buying the business as of the date they take control of the company, and they have an opportunity to close the books and validate the purchase price components post-acquisition. On the negative side, purchase price adjustments are complicated to negotiate and can result in costly and time-consuming disputes following closing.
European Approach: Lockbox-Style Deals
In contrast, in Europe most private company acquisitions involve a fixed equity price based on a set of (typically unaudited) accounts as of a recent historical date. This approach is coupled with a set of “locked box” covenants that prevent dividends and other value leakage from the target to the sellers between signing and closing.
Benefits of the lockbox approach include certainty of pricing at closing, which can be beneficial to both buyer and seller, but may be particularly valuable to a seller looking to distribute maximum proceeds to its investors. The main drawback of a lockbox-style deal is the possibility that the buyer pays more – or the seller receives less – than the company is actually “worth” at closing based on performance between signing and closing. However sellers often seek compensation for this by expecting buyers to add a daily coupon to the agreed equity price which represents the profits accruing over this period.
Possible Trend: Increased Use of Lockbox-Style Deals in the U.S.
In the last year, we have seen an increasing number of U.S. private company acquisitions using a lockbox or modified lockbox approach. While still a small minority of deals, we would expect that U.S. sellers – perhaps recently emboldened by seller-favorable market conditions – may start opting for the pricing certainty that the lockbox approach affords.
Contractual Protection/Rep & Warranty Insurance
U.S. Approach: Seller Indemnity/R&W Insurance
For many years, U.S. deals fell into two categories with respect to post-closing recourse for breaches of representations and warranties. Public company acquisitions, as well as acquisitions of large target companies (generally those with an enterprise value of $1 billion or more) have long been structured with no seller indemnification. Smaller private company deals, on the other hand, historically included some level of indemnification, which was provided pro rata by all selling shareholders – selling PE sponsors and management alike. However, in the seller-friendly deal environment of the last two years, we have seen the size threshold for no-seller-indemnity deals fall lower and lower – with many deals in the $500 million-$1 billion range structured as “walk-away” deals for sellers, and even sellers of companies valued in the $250 million-$500 million range enjoying these favorable terms with increasing frequency. A major factor enabling this trend toward walk-away deals is the tremendous increase in the use of representation and warranty insurance policies, which have become much more attractively priced and more widely available in recent years. As a result, many buyers expecting some level of post-closing recourse for failures of representations and warranties are replacing some or all of the traditional seller indemnity with an R&W insurance policy in order to obtain the protection they need while still providing attractive walk-away terms to sellers. Weil has written a number of articles detailing the benefits and drawbacks of representation and warranty insurance relative to seller indemnification, one of which can be found here.
European Approach: Management Indemnity
In European deals involving private equity sellers, warranties regarding the condition of the business (as distinct from “fundamental” warranties as to ownership of shares, etc.) are typically given only by management. In these cases, the buyer’s recourse for breaches of these business warranties is typically limited to a percentage of deal consideration received by management, which may be quite small relative to overall deal value. Under this approach, buyers may have increased confidence in the warranties about the business, since the managers responsible for making such warranties have skin in the game. However, as a downside, the overall level of post-closing protection for warranty breaches is likely very low. Warranty and indemnity insurance has been available in Europe to bridge this gap in buyer contractual protection for many years but its popularity ebbs and flows depending on its cost and effectiveness as a product (coverage, policy terms etc.). Similarly to the U.S., warranty and indemnity insurance has seen some recent resurgence based on lower policy premiums and good coverage driven by insurers having raised their game and improved their product and service offering. It is now possible to get insurance coverage in Europe for a wide range of possible warranty breaches and/or crystallization of indemnities in a short period of time and even, on occasion, with a deductible payable by the buyer only (i.e. without requiring the seller or management to go ‘on risk’ for the warranties they are giving).
Possible Trend: Convergence of Increasing Use of R&W Insurance in the U.S. and Europe
We have started to see increased use of representation and warranty insurance policies in both U.S. and European deals. It is now the case that insurance is typically at least considered as an option in the majority of transactions and the improved product offering from insurers means that there is flexibility in policy premiums and terms not seen before in the market.